With many OTC derivatives migrating to
exchange-like platforms, buy-side firms will need to centrally clear trades
they didn't have to previously. The primary outlay relates to the need to post
initial margin to cover OTC derivatives positions and manage variation margin,
i.e. the amount of collateral required by a central counterparty to cover
changes in an instrument’s value.

The centralised clearing of standardisable
OTC derivatives is meant to help achieve the Group of 20 goal of reducing
systemic risk in the financial market, through use of more formalised
structures that encourage transparency and require firms to take more
responsibility for their swaps exposures. The three core pillars of the G-20’s
plan called for exchange-trading and central clearing of swaps that can be
standardised and better quality trade reporting. Separately, higher capital
charges will also be levied for exotic swaps that cannot be standardised and
remain bilateral, while Basel III could limit banks’ ability to facilitate such
deals.

How
much more collateral will be needed?

It’s hard to be precise. New clearing
obligations could both encourage and discourage trading in the new OTC
landscape, as firms see the instruments as safer, or conversely, too expensive
for their hedging or exposure requirements.

But one thing is for sure. Compared to the sometimes
minimal costs the buy-side pays now under bilateral agreements, the increase
for some firms could be astronomical.

The International Monetary Fund estimated
in a recent study that US$300 billion worth of new collateral would be needed to
support existing swaps positions. This figure was calculated on a netted basis,
which means that if clearing houses do not interoperate effectively, the amount
could rise to an breath-taking US$3 trillion.

Right now, initial margin is rarely
requested under bilateral deals and custodians handle the variation margin
requirements on a OTC swap trade directly with the end-client.

From having almost nothing to do from a
clearing and collateral perspective, the buy-side now has to take on this
collateral burden and figure out the best way to manage access to clearers,
which could require a total revamp of internal processes.

Where
will the industry find this extra collateral?

Good question. It is important to remember
that the jury is still out on the type of collateral regulators will demand,
but many expect the list to include cash and highly-rated bonds. Certain
clearing houses have broadened the assets they accept as collateral, such as gold
bullion and some forms of corporate debt. However, central counterparties are building
this list slowly, so that risk does not creep back into the system.

But many industry observers are worried
that there is simply not enough good quality collateral to go around. The
issues faced by various European economies means that sovereign bonds that were
once considered safe are now seen as risky, further reducing the options
available for meeting collateral requirements. As economic woes continue, the
amount of acceptable collateral will fluctuate.

How
prepared are the buy-side to meeting clearing and collateral demands?

The ability to meet collateral demands will
largely depend on the type of buy-side firm you are. A boutique asset manager
or hedge fund wont have as many assets on their books as an insurance money
manager that typically has a larger inventory to put to work, for example.

Solutions to help firms optimise their use
of collateral have recently emerged from the likes of Euroclear, Omgeo and
SunGard, while brokers are offering collateral transformation services,
leveraging the assets they hold on repo and securities financing desks.

But it’s likely that most buy-side firms
will take their time. Since Lehman’s collapse, end-clients have demanded that
the buy-side shore up their processes, which they have done through restructuring
of credit support annexes, beefing up internal and counterparty risk controls
and tighter management of collateral. This means the systemic risk issues
perhaps aren’t as evident as they were pre-Lehman.

The buy-side could also find it tough to
share the cost burden of the new clearing obligations with its end-clients.

The sentiment among long-only firms seems
to be, why rush for no obvious commercial benefit? According to one head of
trading at a large asset manager, his firm had set a timeline of 18 months for
revamping internal process.

Change and higher costs are coming, but
maybe not as soon as you think.